The Foreign Earned Income Exclusion is not a given—You have to play by the rules

The Foreign Earned Income Exclusion is not a given—You have to play by the rules

Many taxpayers I have seen over the years were under the assumption that if they didn’t owe the IRS money, or, better yet, if the IRS owed them a refund, there was no rush to file a tax return. When they eventually filed, if ever, they thought they could still take advantage of all the deductions, credits, and exclusions. But that’s not the case; not filing can cost more than just the refund.

Last year, I was contacted by an American I’ll call Eric, who had been living and working in the Netherlands for about 3 years. The first year was hectic for Eric as he adjusted to a new job, in a new country, and he failed to file a tax return in the U.S. When he finally filed his U.S. tax return last year with the help of a local tax preparer, he also filed his previous years’ returns after receiving a notice from the IRS that they had filed a substitute for return for him.

His tax preparer prepared the delinquent returns for Eric and claimed the Foreign Earned Income Exclusion (FEIE). Remember, if you are a U.S. citizen or resident alien , you are taxed on your worldwide income. You may, however, qualify for the FEIE, allowing you to exclude up to a certain amount of foreign earned income—for 2016 the amount is $101,300.

Imagine Eric’s surprise when he received a letter from the IRS disallowing his exclusion based on the fact that he had filed a delinquent return. This is when he came to see me. See, the IRS can deny the FEIE if you don’t timely file a tax return, and the IRS discovers the delinquency before you file. Since the IRS filed a substitute return for Eric, they discovered his failure to timely file and claim the FEIE.

Many taxpayers overseas don’t file because they think if the IRS ever comes looking for them (as in Eric’s case) they will just file and claim the FEIE at that time, and the exclusion will just wipe out any tax liability. But it doesn’t work that way. The reality is, once the IRS discovers your failure to timely file and claim the FEIE, you likely won’t qualify for the FEIE.

Luckily for Eric, the Netherlands’ income tax rate is higher than the U.S. so, although he didn’t qualify for the FEIE, he was able to claim the Foreign Tax Credit, which eliminated his U.S. tax liability. Eric would not have been so fortunate had he lived in a country with an income tax rate lower than that of U.S.

You have to play by the IRS rules if you want to reap the benefits of the tax code.